Introduction: An Update on Brexit

As we approach the final eight months before Brexit (in theory) one of the main sticking points in the negotiations remains the future trade relationship that the EU and the UK will adopt. This is a legitimate concern given the vast amount of tariff free trade that currently takes place between the two. However, whilst figuring out a trade deal concerning physical goods is of paramount importance to the UK, it also needs to determine, along with the other 27 EU members, what to do when it comes to greenhouse gas emissions trading.

What is the Emissions Trading System?

Currently, the UK is party to the European Union Emissions Trading System (EU ETS). There are 31 members including all the EU member states. The system covers aviation and energy intensive installations, such as power stations and industrial plants. As part of the EU ETS, the total amount of certain greenhouse gases that can be emitted by covered installations is capped. Within this cap, companies can buy, sell or trade allowances. The limit on the total number of allowances available ensures that they have a value. The system covers ‘roughly’ 45 percent of the EU’s greenhouse gas emissions. After each year, companies must report their emissions and ‘surrender’ their allowances. There must be enough allowances surrendered to cover the total amount of emissions from the company (one allowance is equivalent to one ton of CO2). Otherwise, companies will face paying hefty fines. Any left-over allowances can be retained by the company for future use. The idea is that the amount of allowances available on the market is reduced over time, thus lowering the amount of emissions. So, this is all well and good but what position will the UK take following Brexit?

Participation in 2018

The working assumption of the EU is that the UK will cease to participate in the system immediately on exit from the organization.  This was born out of their concern that the UK would not honor its obligations for the 2018 calendar year. This is because the UK’s stated intention is to leave the EU on March 29, 2019, one day before emission reports for 2018 are due and a month before the deadline to surrender allowances on April 30, 2019. The EU worry was that the UK would fail to enforce the system, as it would no longer be legally obliged to by the time the deadlines came around, leading to companies selling all their allowances which would artificially inflate the amount available and distort the market. In fact, the level of concern at this scenario was so high, that it was proposed to distinguish UK allowances from other allowances and restrict them from being used for compliance in 2018. In response, the UK offered to bring forward the compliance deadlines. On November 30, 2017 the EU Climate Change Committee approved this approach and the following week the UK enacted these earlier deadlines in law. The deadlines to report emissions and surrender allowances for 2018 emissions have been brought forward to March 11, 2019 and March 15, 2019 respectively. The UK Government has also committed to punishing any companies that do not comply with these deadlines, even if this action has to be taken after Brexit.  

Where the UK finds itself with regards to the EU ETS on March 30, 2019 will depend on a number of factors, most significantly the terms of the final overall deal.

Although the UK succeeded in averting what would effectively have been an early exit from the EU ETS and provided assurances to the EU and affected UK businesses for 2018, this doesn’t give any clues to the UK’s plans beyond Brexit.  Where the UK finds itself with regards to the EU ETS on March 30, 2019 will depend on a number of factors, most significantly the terms of the final overall deal (if there is indeed a deal reached in time). However, at this point, it appears that there are four (or five) possible paths that the UK could take.

1. Withdraw from the EU ETS on Brexit day

This is the outcome that would be most likely if the Government sticks to the ‘Hard Brexit’ approach which was the line when the Brexit negotiations began. Although it appears that this stance may have softened recently, this would satisfy the ‘Brexit means Brexit’ rhetoric and judging from the earlier mentioned concerns, may be what the EU27 still expects. In this event, the UK would no longer be allocated allowances and any left-over allowances from 2018 could not be traded with installations based elsewhere in the EU. This would probably require an adjustment from the EU27 of the allowances made available on the market, however it would be unlikely to have any significant or destabilizing effect. In terms of how this would affect the UK, it is likely that an alternative system would be introduced. The Climate Change Act 2008 commits the UK government by law to reducing greenhouse gas emissions by at least 80 percent of 1990 levels by 2050, so the UK will need to find some method of reducing its carbon output. Also, the Greenhouse Gas Emissions Trading Scheme Regulations 2012, which implement the EU ETS in UK law, will remain in force following Brexit.  It may be that they are adapted to copy the EU system into a UK-only one. If not, something will need to be done to avoid it becoming a dead letter piece of legislation. If the UK does leave the system on Brexit day, it may take this as an opportunity to implement more innovative instruments and policies.

2. Remain part of the EU ETS after Brexit

This is an option that may still be available to the UK, particularly after it appears to have softened its stance in recent weeks with talk of implementing ‘regulatory alignment’ with the EU. Also in the UK’s favor if it wants to go down this route is the fact that Iceland, Liechtenstein and Norway participate in the scheme, despite not being EU member states. However, what these states also have in common is that they are members of the European Economic Area (EEA) which allows them to be part of the EU’s single market. It is unclear if membership of the EEA, or at the very least, the single market would be a requirement for continued participation in the EU ETS. Although staying in the single market does not appear to be on the agenda for the current Brexit negotiating team, 15 months is an awful long time in politics, and a lot could change.  

3. Withdraw from the EU ETS at the end of phase three

Currently, the EU ETS is in its third phase of operations. Phase three runs from 2013-2020 with phase four beginning in 2021 and running up until 2030. The EU has agreed to reforms which will enter into operation during phase four after criticism that phase three prices were too low. Phase four will attempt to combat this by tightening the amount of surplus allowances on the market and raising prices. It may be tempting for both parties to maintain the status quo and see out phase three before the reforms kick in. This type of transitional period would ensure a smooth ending to phase three and give each party time to get its house in order. The EU would be given time to prepare the phase four reforms knowing that the UK will no longer be a part of the system and it would also prevent a regulation gap in the UK itself. If used correctly, the UK could benefit from the transitional period as a chance to develop its own regulation and policy which could then be implemented from 2021. This option would be attractive to both parties as it minimizes any potential disruption and ensures that both sides continue to work towards their environmental targets.

4. Integrate the UK’s system within the EU ETS

Once the UK establishes its own system integrating it within the EU ETS may be an option. In this respect, the UK would be following the lead of the EU and Switzerland who recently came to such an agreement. The EU-Swiss link, once ratified, will allow EU ETS participants to use allowances from the Swiss system for compliance, and vice versa. If the UK does establish its own system, integration could appeal to the EU in terms of co-operation and working towards the shared objectives of the Paris Agreement. Of course, if the UK and EU were to go down this path it would probably take even longer than the Brexit negotiations. After all, the EU and Switzerland took seven years just to sign an agreement. And it would also be dependent on the UK establishing a similar cap-and-trade system that could fit back in with the EU ETS framework. If the parties do eventually choose to go down this road, it will be a long one.

5. And a bonus fifth… Cross-continental co-operation?

If the UK really wants to get creative, could it try and establish some sort of cross-regional emissions trading scheme to rival the EU ETS? Especially with the current UK Government so keen to emphasize the strength of its ties with North America. And if the UK were to leave the EU on bad terms, could Theresa May and Donald Trump hold hands and lead us into a brave new world of emissions trading? Well, in a word, no. Ignoring the high probability that neither will be in charge by the time such talks could come around, it would be impossible to overcome the logistical, political and administrative nightmares that this would create. Not to mention the questions over political sovereignty it would raise. Although this scenario is not credible and maybe seems a tad flippant, it can be used to illustrate the point that the UK would be well advised to co-operate with the EU27 on emissions and should stick to more traditional trade with the rest of the world.

Which route will the UK go down?

Looking at these options, perhaps the most sensible path that the UK should take is option three, provided a transitional deal is also struck up for other aspects of Brexit. If a transitional phase is implemented, where the UK continues to have access to the single market for some time after March 30, 2019, it would make sense to see out phase three and then have both parties start with a clean slate in 2021. Once the UK has its own system up and running, it could then enter into negotiations on the type of agreement proposed in option four, following the EU-Swiss model. This way, it would satisfy both the Brexit hardliners who are calling for a total exit and those who want to continue co-operation with the EU. It would also avoid uncertainty for UK businesses over their obligations for 2019 and 2020 and allow them to at some point in the future, benefit from the reformed EU ETS.  Although I would advocate this as the best course of action, we have seen from the way the Brexit talks have gone so far that it’s impossible to confidently predict the UK’s next move.

Actions undertaken by the European Union

Even if the negotiation phase is still ongoing, the European Union already adopted certain measures in order to prevent negative impact of Brexit on the functioning of such system. As a matter of fact, allowances for verified emissions in the year 2018 must be surrendered by April 30, 2019, whereas the UK's EU membership will cease on March 29, 2019 (unless extended by unanimous agreement), meaning that UK operators would not have to surrender allowances for their 2018 emissions. Such a situation would undermine the environmental integrity of the EU ETS by further increasing the existing surplus of allowances.

Once the UK has its own system up and running, it could then enter into negotiations on the type of agreement proposed in option four, following the EU-Swiss model.

In order to address this concern, on February 13, 2018 the European Commission published Commission Regulation EU/2018/208 of February 12, 2018 which amends Regulation EU/389/2013 establishing a Union Registry. Such Regulation aims at providing safeguard measures for protecting environmental integrity of the European Union Emissions Trading System (EU ETS) once compliance by the United Kingdom (UK) authorities (and operators) and EU law ceases to apply to the UK.

Despite the publication date, Regulation EU/2018/208 enters into force retroactively as a matter of urgency and applies from January 1,2018; the measures apply to all allowances allocated for free, received in exchange of international credits or auctioned in 2018.

Regarding its content, this Regulation firstly sets out that any ETS allowances, auctioned or allocated for free, have to be marked with a country code and made distinguishable according to the year of creation.

Secondly, it establishes that allowances marked by the UK will not be accepted for surrender; nevertheless, those issued by the UK in 2018 may be surrendered if

  1. EU law would not cease to apply in that Member State by 30 April 2019 or
  2. it is sufficiently ensured that the surrender of allowances will take place in a legally enforceable manner by no later than 15 March 2019.

Therefore, to recap, ETS allowances issued by the United Kingdom (UK) are not accepted for surrender, except for the allowances issued for the calendar year 2018.

According to some analysis, the measure proposed by the Commission could lead to a fragmented market for EU allowances, with UK allowances trading at a discount to allowances issued by other Member States. Forward trading contracts would also be affected and become more complex. Emissions exchange would have to adapt their contract definitions. Other impacts might be increased volatility, uncertainty about compliance obligations, lost auction revenue for the UK, and a temporary closure of the EU ETS registry.